c h a p t e r seventeen © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. Prepared by: Fernando & Yvonn Quijano Macroeconomics in an Open Economy

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 17: Macroeconomics in an Open Economy 2 of 29 After studying this chapter, you should be able to: Explain how the balance of payments is calculated. Explain how exchange rates are determined and how changes in exchange rates affect the prices of imports and exports. Explain the saving and investment equation. Explain the effect of a government budget deficit on investment in an open economy. Discuss the difference between the effectiveness of monetary and fiscal policy in an open economy and in a closed economy. Chinese Towels Invade Japan LEARNING OBJECTIVES In this chapter, we look more closely at the linkages among countries at the macroeconomic level. 5

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 17: Macroeconomics in an Open Economy 3 of 29 The Balance of Payments: Linking the U.S. to the International Economy LEARNING OBJECTIVE 1 Open economy An economy that has interactions in trade or finance with other economies. Closed economy An economy that has no interactions in trade or finance with other economies. Balance of payments The record of a country’s trade with other countries in goods, services, and assets.

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 17: Macroeconomics in an Open Economy 4 of 29 The Balance of Payments: Linking the U.S. to the International Economy The Current Account Current account The part of the balance of payments that records a country’s net exports, net investment income, and net transfers. THE BALANCE OF TRADE Balance of trade The difference between the value of the goods a country exports and the value of the goods a country imports.

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 17: Macroeconomics in an Open Economy 5 of 29 The Balance of Payments: Linking the U.S. to the International Economy The Balance of Payments of the United States, 2004 (billions of dollars) 17 – 1 CURRENT ACCOUNT Exports of Goods$807 Imports of Goods–1,473 Balance of Trade–666 Exports of Services344 Imports of Services–296 Balance of Services48 Income Received on Investments380 Income Payments on Investments–349 Net Income on Investments31 Net Transfers–81 Balance on Current Account–668

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 17: Macroeconomics in an Open Economy 6 of 29 The Balance of Payments: Linking the U.S. to the International Economy The Balance of Payments of the United States, 2004 (billions of dollars) 17 – 1 cont. FINANCIAL ACCOUNT Increase in foreign holdings of assets in the United States$1,440 Increase in U.S. holdings of assets in foreign countries–856 Balance on Financial Account584 BALANCE ON CAPITAL ACCOUNT -1 Statistical Discrepancy85 Balance of Payments0

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 17: Macroeconomics in an Open Economy 7 of 29 The Balance of Payments: Linking the U.S. to the International Economy The Current Account NET EXPORTS EQUALS THE SUM OF THE BALANCE OF TRADE AND THE BALANCE OF SERVICES

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 17: Macroeconomics in an Open Economy 8 of 29 The Balance of Payments: Linking the U.S. to the International Economy The Financial Account Financial account The part of the balance of payments that records purchases of assets a country has made abroad and foreign purchases of assets in the country. Net foreign investment The difference between capital outflows from a country and capital inflows, also equal to net foreign direct investment plus net foreign portfolio investment.

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 17: Macroeconomics in an Open Economy 9 of 29 The Balance of Payments: Linking the U.S. to the International Economy The Capital Account Capital Account The part of the balance of payments that records relatively minor transactions, such as migrants’ transfers, and sales and purchases of nonproduced, nonfinancial assets. Why Is the Balance of Payments Always Zero? Understanding the Arithmetic of Open Economies 17-1 LEARNING OBJECTIVE 1 Don’t Confuse the “Balance of Trade,” the “Current Account Balance,” and the “Balance of Payments”

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 17: Macroeconomics in an Open Economy 10 of 29 The Foreign Exchange Market and Exchange Rates LEARNING OBJECTIVE 2 Nominal exchange rate The value of one country’s currency in terms of another country’s currency.

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 17: Macroeconomics in an Open Economy 11 of 29 Exchange Rates in the Financial Pages The financial pages of most newspapers provide information on exchange rates. EXCHANGE RATE BETWEEN THE DOLLAR AND THE INDICATED CURRENCY UNITS OF FOREIGN CURRENCY PER U.S. DOLLAR U.S. DOLLAR PER UNIT OF FOREIGN CURRENCY Canadian dollar Japanese yen Mexican peso British pound Euro

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 17: Macroeconomics in an Open Economy 12 of 29 The Foreign Exchange Market and Exchange Rates Equilibrium in the Market for Foreign Exchange Equilibrium in the Foreign Exchange Market

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 17: Macroeconomics in an Open Economy 13 of 29 The Foreign Exchange Market and Exchange Rates Equilibrium in the Market for Foreign Exchange Currency appreciation Occurs when the market value of a currency rises relative to another currency. Currency depreciation Occurs when the market value of a currency falls relative to another currency. Don’t Confuse What Happens When a Currency Appreciates with What Happens When It Depreciates

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 17: Macroeconomics in an Open Economy 14 of 29 The Foreign Exchange Market and Exchange Rates Three main factors cause the demand and supply curves in the foreign exchange market to shift:  Changes in the demand for U.S.-produced goods and services and changes in the demand for foreign-produced goods and services.  Changes in the desire to invest in the United States and changes in the desire to invest in foreign countries.  Changes in the expectations of currency traders about the likely future value of the dollar and the likely future value of foreign currencies. How Do Shifts in Demand and Supply Affect the Exchange Rate?

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 17: Macroeconomics in an Open Economy 15 of 29 The Foreign Exchange Market and Exchange Rates How Do Shifts in Demand and Supply Affect the Exchange Rate? SHIFTS IN THE DEMAND FOR FOREIGN EXCHANGE Speculators Currency traders who buy and sell foreign exchange in an attempt to profit by changes in exchange rates. SHIFTS IN THE SUPPLY OF FOREIGN EXCHANGE ADJUSTMENT TO A NEW EQUILIBRIUM

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 17: Macroeconomics in an Open Economy 16 of 29 The Foreign Exchange Market and Exchange Rates How Do Shifts in Demand and Supply Affect the Exchange Rate? ADJUSTMENT TO A NEW EQUILIBRIUM Shifts in the Demand and Supply Curve Resulting in a Higher Exchange Rate

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 17: Macroeconomics in an Open Economy 17 of 29 The Foreign Exchange Market and Exchange Rates The Real Exchange Rate Real exchange rate The price of domestic goods in terms of foreign goods. Real exchange rate = Nominal exchange rate

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 17: Macroeconomics in an Open Economy 18 of 29 The International Sector and National Saving and Investment LEARNING OBJECTIVE U.S. Imports and Exports, Net Exports Equal Net Foreign Investment

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 17: Macroeconomics in an Open Economy 19 of 29 The International Sector and National Saving and Investment Net Exports Equal Net Foreign Investment Current Account Balance + Financial Account Balance = 0 or, Current Account Balance = -Financial Account Balance or, Net Exports = Net Foreign Investment

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 17: Macroeconomics in an Open Economy 20 of 29 The International Sector and National Saving and Investment Domestic Saving, Domestic Investment, and Net Foreign Investment National Saving = Private Saving + Public Saving S = S private + S public Private Saving = National Income – Consumption - Taxes S private = Y – C – T Government Saving = Taxes – Government Spending S public = T – G

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 17: Macroeconomics in an Open Economy 21 of 29 The International Sector and National Saving and Investment Domestic Saving, Domestic Investment, and Net Foreign Investment Remember the basic macroeconomic equation for GDP or national income: Y = C + I + G + NX Saving and investment equation An equation showing that national saving is equal to domestic investment plus net foreign investment. National Saving = Domestic Investment + Net Foreign Investment S = I + NFI

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 17: Macroeconomics in an Open Economy 22 of 29 Arriving at the Saving and Investment Equation 17-3 LEARNING OBJECTIVE 3

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 17: Macroeconomics in an Open Economy 23 of 29 The Effect of a Government Budget Deficit on Investment LEARNING OBJECTIVE The Twin Deficits,

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 17: Macroeconomics in an Open Economy 24 of 29 Why Is The United States Called the “World’s Largest Debtor?” Large current account deficits have resulted in foreign investors purchasing large amounts of U.S. assets.

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 17: Macroeconomics in an Open Economy 25 of 29 Monetary Policy and Fiscal Policy in an Open Economy LEARNING OBJECTIVE 5 Monetary Policy in an Open Economy Fiscal Policy in an Open Economy

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1 st ed. CHAPTER 17: Macroeconomics in an Open Economy 26 of 29 Balance of payments Balance of trade Capital account Closed economy Currency appreciation Currency depreciation Current account Financial account Net foreign investment Nominal exchange rate Open economy Real exchange rate Saving and investment equation Speculators